Shares of American railroads have been enjoying an even stronger rally than the S&P 500.  Despite so much intense media focus on revolutionary technology firms such as Netflix and Apple, good, old-fashioned railroads have been chugging along just fine. Apple earns profits on phones that it upgrades every few months; the railroads make money on locomotives, some of which are thirty years old.  Facebook was launched in 2004.  The Union Pacific was named after the “Union” won the Civil War.  Yet Norfolk Southern shares have jumped almost 50% in the past year, with Union Pacific not far beyond.  Can the railroad rally continue?  Will investors allocate more to rails in 2018?
 
Some green lights are flashing brightly. Railroads benefit from the growing economy.  Simply put, more spending by consumers and more business investment translates into loading more items on railcars.  In 2017, rail traffic climbed almost 3%, according to the Association of American Railroads. Intermodal traffic was especially strong.  This is key because intermodal statistics include containers that could, instead, be carried by trucks.  Therefore, rising intermodal traffic may signal a stronger economy and that rails are competing well with trucks. 
 
The new tax law is also a boon to rails:  First, it slashes the corporate tax rate from 35% to 21%, aiding after-tax earnings in a year in which corporations are earning record sums.  Just as important for the rails, though, the new law allows companies to immediately expense purchases of new equipment.  This move boosts the rails in two very different ways.  First, it gives them the wherewithal to upgrade their own equipment.  Class 1 rails like CSX, Norfolk Southern, and Union Pacific are attempting to expand their ownership of the supply chain.  This means building, installing, and owning their own facilities at ports and terminals.  Expensing will advance this cause.  Second, expensing will generate more freight for railroads to carry.  When Navistar ships more engines from Indiana to its customers, those engines will likely ride in a railroad car.  In the end, the tax law will lead to more efficient railroad systems and more customers for the railroads.   
 
But there are risks, too.  Consider the array of goods shipped by rail.  Rails generate significant profit from transporting automobiles—indeed, 70 percent of new autos get to dealers by rail, according to the Alliance of Automobile Manufacturers.  A single train may carry 750 cars, and America’s 70 automobile manufacturing plants are found not just in Michigan, but also in Texas, Tennessee, Georgia, etc.  Yet auto sales seem to have peaked.  With the economic recovery reaching its ninth year in 2018, there’s little pent-up demand.  Combine this with slightly higher interest rates, Uber, and a future of self-driving cars, and it’s possible that rails will have to shave back their expectations for shipping automobiles.  This year auto analysts expect sales to fall below 17 million units, for the first time in several years.
 
Commodity prices will impact the rails as well.  Higher oil prices will likely lead to more fracking and the uncapping of wells.  Railroads like Union Pacific ship a great deal of frac sand, and should benefit from the upturn. However, other commodities, such as grains, remain weak.
 
The biggest risk for rails may come on the trade front.  With NAFTA negotiations underway, a falling out could threaten rail profits, especially for Kansas City Southern, which has often been called “the NAFTA Railroad” due to its cross-border routes.  If the Trump administration pulls out of NAFTA, it will threaten automobile imports from Mexico and Canada, as well as agricultural trade in both directions.  The U.S. sends corn, chickens, and wheat to Mexico; Mexico ships tomatoes and avocados north of the border.  U.S. farm interests are trying to pressure the White House to stay within NAFTA, as Mexico buys 12% of U.S. agricultural exports.  Last fall, Kansas City Southern boosted its dividend by about 10%.  Union Pacific has paid dividends for 118 years, and it also boosted its dividend by nearly 10%.  It will be harder for rails to stick to this happy trend if the northern and southern borders become impenetrable to trade.          
 
The railroads may be roaring into 2018, but trade disputes and sagging auto sales could raise a few caution flags.

JANET YELLEN IS STUMPED.  SHE IS SAYING GOODBYE TO THE FEDERAL RESERVE BOARD.  BUT SHE LEAVES BEHIND A PUZZLE SHE COULD NOT SOLVE, EVEN WITH A BATTALION OF ECONOMISTS, MATHEMATICIANS, AND EVEN PHYSICISTS HELPING:  WHY HAS INFLATION STAYED SO LOW DESPITE AN ECONOMIC RECOVERY?  WHEN YOU TWIRL AROUND THE INFLATION QUESTION, LIKE A RUBIK’S CUBE, IT BRINGS UP OTHER MYSTERIES:  HOW CAN THE 10-YEAR U.S. TREASURY SIT AT 2.40%, NOT FAR FROM RECORD HISTORICAL LOWS?  WHY IS THE YIELD CURVE NEARLY FLAT, WITH A MERE 4.1% UNEMPLOYMENT RATE AND RECORD STOCK MARKET PRICES?

While many forces impact the economy, we would argue that the “gig economy” is helping to tamp down inflationary forces.  This has important implications for real estate, construction, and hotels.  Consider:  Airbnb boasts over 4 million listings worldwide, four times as many as in 2015, more than the top five hotel brands combined, and about ten times as many as Hilton.  Airbnb served over 30 million guests last year.  In the U.S., Airbnb has effectively increased the number of available rooms by about 25 percent.

With that massive supply influx, Average Daily Rates and RevPar for hotels lag GDP growth.  And more supply is coming online, with nearly 200,000 U.S. hotel rooms under construction and untold apartment owners and speculators jumping into the Airbnb game.  Last year, hotel group Accor purchased Onefinestay, a home and apartment rental startup, which had earlier attracted an investment from Hyatt.

Airbnb may make it tougher for hotels, but here’s the upside:  By offering more choices to price-sensitive conventioneers and business travelers who can take advantage of online room rentals, Airbnb encourages more conventions.  An increase in the number of corporate meetings and conventions will boost demand for well-managed mainstream hotels. We expect that the stronger economy (GDP growing over 3 percent) will energize the convention sector in 2018.

The Gig Economy also shows up in shared office firms like WeWork, which recently announced it was buying the flagship Lord & Taylor store on Fifth Avenue in New York for $850 million.  Lord & Taylor, owned by Hudson Bay, will shrink its square footage of floor space.  But there’s an upside for the retailer. Those millennial “WeWorkers” will stroll through the aisles on the ground floor of Lord & Taylor, while making their way upstairs to the shared office spaces of WeWork.  They may stop to shop for perfume, makeup, or jeans. Hudson Bay may launch a similar strategy for the landmark Saks Fifth Avenue, a dozen blocks to the north.  These sorts of moves, which optimize space, effectively boost the supply of land.  More effective supply means less upward price pressure and less inflation.  Less inflation keeps interest rates low.  Cheap borrowing costs encourage corporate expansion.

In the construction sector, the Gig Economy constrains heavy equipment companies from jacking up leasing prices.  Companies like Yard Club and Dozr make it easier for contractors to rent bulldozers and backhoe loaders from others when the equipment is not in use.  After Yard Club racked up $120 million in revenues last year, Caterpillar snatched up the company.   Yard Club’s proprietary “peer-to-peer” software will allow Cat to improve its own my.cat.com portal.  The economic point is this:  we are less likely to see heavy equipment sitting idle, which means that the Gig Economy has effectively boosted the supply of equipment.

The Gig Economy is not the whole story, of course.  The real estate and construction sector face many hurdles that can pressure prices higher.  Builders report labor shortages, while cement and steel prices have climbed about 4 percent in the past year.  Tariff disputes over Canadian lumber can make things worse.  Nonetheless, we recommend that you do not underestimate the role of technology and gigging in tamping down inflation in the sector and in the economy.  Maybe in retirement  Janet Yellen will offer her Washington, DC apartment on Airbnb and rent a backhoe from the Yard Club.

Bitcoin, Housing, and Oil Lead the List of Surprises that Could Shake Markets Next Year
 
Los Angeles, CA (December 18, 2017)

The Beachwood Group, a research and investment firm based in Los Angeles, has revealed Seven Great Investment Surprises for 2018.  To create the list, The Beachwood Group and its global partners scour worldwide financial markets to identify political and economic events that could shake up conventional wisdom.  In some cases, the events would be good news for stocks; in some cases they would be hurt.  The Seven Great Surprises are not forecasts of highly likely events; instead they are aimed to keep investors vigilant as they head into the New Year.

Here are the Seven Great Surprises for 2018:

• Congress and the European Parliament pressure the Federal Reserve Board and the European Central Bank to audit and regulate Bitcoin and other crypto-currencies.  After watching Bitcoin prices catapult in 2017, central banks worry that too many small investors are vulnerable to manipulation and “secret “mining” operations.  The government assault scares Bitcoin investors, and gold prices jump as an alternative.
• “Dead Malls” come back to life.  After being nearly exterminated by Amazon and other online retailers, malls re-emerge as “experiential destinations.”  Consumers rediscover town center “storefront” malls, where they can see live shows, take exercise classes, and try out eclectic restaurants.
• Housing sputters in high tax states like California, New Jersey, and Massachusetts under the force of two factors:  (1) The new Tax Act limits state and local tax deductions, and (2) rising interest rates squeeze new borrowers.
• Oil prices leap before dropping down again.  A stronger world economy pushes energy prices higher on fears of a shortage. Airline and chemical shares wobble. But then oil producers re-open previously capped wells, sending prices back down in the second half of the year.
• Pro-western Middle East powers including Saudi Arabia, the UAE, and Israel form a tacit “alliance against barbarism” and conduct joint military exercises to prepare for any attacks by ISIS or Iran.  Crown prince Mohammed bin Salman of Saudi Arabia is hailed as a visionary, as women drive themselves to pro-government rallies before heading off to movie theaters.
• A movement begins on college campuses to ban private automobiles and to shame automobile owners.  The rise of Uber, Lyft, and self-driving cars leads Generation Z to view autos as unnecessary symbols and sources of soot and vanity.
• A Wikileaks clone reveals secret deliberations of the Chinese Politburo and the embarrassing riches amassed by “princelings,” sons and daughters of high officials.  Fearing a brutal purge reminiscent of the Cultural Revolution, Chinese billionaires and multi-millionaires dump Yuan onto the market, pushing down the value of the currency, and pushing up real estate prices in Vancouver and Melbourne.

 
The views expressed reflect the current opinion of The Beachwood Group on this date. These views are subject to change and The Beachwood Group is not engaged to advise you of any changes in the views expressed.